We previously published an article on returns and how the reporting of returns can confuse members. We emphasised that member education is paramount and should continually be driven especially in the context of planning for retirement.
We presented a table in this article (https://axiomatic.co.za/news/returns-reality-vs-reality/) with fictitious returns and have since received a lot of feedback questioning whether the order in which returns are achieved will change the outcome. This is represented in Table 1 below:
This is also shown graphically below.
This is also shown graphically below.
The final outcome is the same as the original table even when the order of returns is randomised; and therefore the annualised return is the same as in the previous article – 4.76%, i.e. the same ‘average’ return of all the highs and lows which gives you the same final value
So, does the sequence/order of returns matter? Not if you leave a lumpsum invested without adding or withdrawing.
So then where does the risk lie? The risk lies when you introduce contributions (as you do in any retirement fund while you are saving) or withdrawals (as you do in if you are living off your savings).
In Table 4, we now introduce regular contributions.
The final outcome is different with the addition of contributions. This vast difference is represented in the graph below:
- With no contributions, Table 3 shows the outcome to be equivalent even after randomising the order of returns.
- With contributions, a scenario applicable to people saving for retirement, the order of returns matter.
So now what?
In a world where:
- statistics show the clear majority will not have enough saved for retirement;
- balanced with appropriate risk, people want higher return, as they don’t want to contribute more or work longer and
- the order of return matters when saving for retirement but
- you cannot control returns or the sequence/order in which you receive them,
What can you do?
A possible solution is to improve the certainty of the returns. This will mean that retirees can plan with more certainty even if the outcome may still not be sufficient.
Now imagine instead of targeting a CPI + 5% portfolio with a certain level of risk, you target a CPI + 3% with a lower risk (lower risk, lower return) but you also simultaneously take care of sequence risk.
This may take the shape of portfolios which are designed to minimise the impact of periods with negative return but simultaneously also slightly lower the returns when markets perform well. Smoothed bonus portfolios, while they cannot reduce or mitigate sequence risk can increase certainty through its smoothing mechanism. Naturally the impact of fees needs to be considered. In any industry, transparency of costs should be a given. This is no different in financial services. Often the true costs of a smooth growth portfolios not understood by those who invest in them. Costs erode returns, and do therefore impact the final outcome. In addition, investors often misunderstand what a smooth growth portfolio is, mistaking it for a guaranteed portfolio, when this is not the case. Recently, a draft notice was issued to the public for comment the prescribed conditions for smoothed bonus products.
Alternatively, one can consider looking at income efficient portfolios., Such portfolios ‘bolster’ returns through regular income distributions. These are typically not considered when returns are reported on and also result in a ‘smoothing’ effect.
While the ultimate solution is to ensure people are educated and then simultaneously save more for longer towards retirement, a practical approach for those who cannot manage this because of day-to-day affordability must be found.
For more information please contact Jonathan Lau on +27 11 305 1949 or firstname.lastname@example.org